Blogs: Christopher K. Potter

For three thousand years China has been at the forefront of monetary innovation. It was the first to legalize gold money in the tenth century BC and two millennia later it issued the world’s first paper currency. Fast forward to 2012 and China is at it again, eclipsing Australia as the largest producer of gold and increasing its monetary gold reserves at an alarming rate. Five years ago China surpassed the US in gold production and five years from now it will own more gold than the US Federal government.

Do not dismiss this as just another example of China’s insatiable appetite for natural resources. It is not. China is preparing for a world beyond the inconvertible paper dollar, a world in which the renminbi, buttressed by gold, becomes the dominant reserve currency.

Lest anyone doubt China’s resolve, just consider the following: The Chinese government has recently removed all restrictions on personal ownership of gold; legalized domestic gold exchange traded funds; is currently purchasing 100% of domestic gold mine production; has imported over 750 tons of gold (27% of global output) in the last 12 months; stated publically its intention to add 1,000 tons per year to its central bank gold reserves; and is buying major stakes in foreign gold mining companies. The scale of this initiative is extraordinary.

Commenting on the recently announced acquisition of African Barrick Gold Ltd. by state-owned China National, CEO Sun Zhaoxue stated, “As gold is a currency in nature, no matter if it’s for state economic security or for the acceleration of renminbi internationalization, increasing the gold reserve should be one of the key strategies of China.” This statement regarding the internationalization of the currency through the production and acquisition of gold reserves is in stark contrast to the attitude of Federal Reserve Chairman Ben Bernanke. He told students at a lecture at George Washington University earlier this year that the problem with the gold standard is that it requires “an awful big waste of resources” to produce the gold. It seems that what we consider waste, China considers essential for the establishment of a sound currency.

There are two important reasons why any of this matters. First, the scale of China’s gold initiative is unprecedented in world history. This alone should make us take notice. Second, China is signaling that the currency wars of the past decade are changing. Soon, the battle will be influenced by gold. Here in the West, we cling to the notion that our experiment with floating exchange rates and unreserved currencies will somehow save the day. We forget that it was only 41 years ago, when the US suspended dollar-gold convertibility, that our current system was born. China suffers from no such delusion. It is voting with its wallet that the experiment has failed. It is preparing for the demise of the US dollar.

Fortunately, we still have something to say about this. As long as the US dollar remains the world’s reserve currency, we can act from a position of strength and credibility. China does not know what the next monetary system will look like – it just knows that when the dust settles, gold will once again be an important monetary asset. The US can avoid being a victim of this uncertain future by designing and implementing a modernized gold standard. We have done it before with great success. In fact, for most of US history, the dollar was defined as a weight unit of gold. It is no coincidence that we enjoyed our greatest economic growth during those periods.

The long-run goal of monetary policy is simple: Supply the economy with the right amount of money to promote healthy economic growth and a stable price level. Determining that amount is impossible for the Federal Reserve. Nevertheless, since 1971, when we said good-bye to the last semblance of a gold standard, we have delegated that responsibility to the Fed and the world’s central bankers. This 40-year experiment has failed. Real economic growth is faltering, and the world’s leading powers are waging a currency war in which success, perversely, is measured by the level of currency weakness rather than strength. What has happened to the idea of a sound dollar?

Because our monetary problems were decades in the making, we forget that over a very long interval (1834 to 1971), interrupted only by war, the US economy enjoyed tremendous economic growth and price stability, thanks largely to a convertible dollar (a dollar defined as a weight unit of gold). Numerous misperceptions about the gold standard keep this fact from today’s debate on monetary reform. Ask the average Washington insider, and he will tell you that the gold standard causes deflation and restricts economic growth. One need look no further than the historical record to understand that these criticisms are false.

Price stability, not deflation, was the hallmark of a dollar convertible to gold both in the 1800s and the pre-1971 20th century (see Charts 1 & 2). The US price level (CPI) was the same in 1914 as it was in 1834. The absence of inflation for almost a century did not come at the expense of economic growth. On the contrary! US real Gross Domestic Product (GDP) grew approximately 4% per year for that entire interval, the greatest period of growth in US history. Even during the period 1914 to 1971, as the gold standard was progressively diluted by the gold exchange standard, the residual link between the dollar and gold restrained the CPI, and promoted robust economic growth. After Nixon suspended convertibility of the dollar to gold in 1971, the CPI began its steep, modern-day ascent and the US economy, while continuing to grow, never regained the growth level and price stability seen from 1834 to 1971.

At the heart of the gold standard’s remarkable history of producing stable prices is the natural alignment of the long-run rate of growth of the above ground gold stock with global population and per capita GDP (see Chart 3). Over long periods, the three variables have grown in direct proportion to each other (0.6%-0.7% per year from 1810 to 1914; 1.4%-1.7% per year from 1914 to 2010). This symmetry is the primary reason why people have used gold as the natural monetary standard throughout history. There is an understanding, based on empirical fact and centuries of production history, that gold will not be overproduced or underproduced relative to population and per capita GDP. It follows, therefore, that when the dollar can be redeemed for a specified weight unit of gold, confidence in the dollar as a reliable measure of wealth increases. Price stability ensues.

At the October 5th Heritage “Conference for a Stable Dollar,” James Grant noted an important irony of the Gold Standard – when the dollar is defined as a weight unit of gold, individuals rarely exchange their paper money for gold. It is only in the absence of a gold standard that they desire gold, a store of value amidst fluctuating paper currencies. Said another way, when the dollar is “as good as gold,” people choose the convenience of the convertible paper dollar.

It is also true, however, that the desire and the freedom to hold gold by all market participants, not just the central banks, is a critical underpinning of the stability provided by the gold standard. Under the true gold standard (1834 to 1914), in the case where the central bank produces an excess of money relative to the economy’s demand for money, market participants will exchange their dollars for gold, and will continue to do so until the central and commercial banks reduce the supply of money such that price stability is restored. It is this spontaneous and automatic market mechanism, rather than the ratio of central bank gold reserves to the money supply, that keeps the price level in check. The gold standard is the solution to today’s monetary problems of currency chaos and financial market instability. While it is not perfect, no other system can match its long record of success in providing stable prices and superior economic growth. We have the map. Let’s use it.

Would it surprise you to know that the "official" rate of inflation in Russia is a lofty 9%? It surprised us until we looked at Russian money supply which has grown at a compounded annual rate of 30% over the last ten years. In light of this, it is easy to wonder why the inflation rate isn't even higher than 9%. Well, according to the following Financial Times article, it is (http://www.ft.com/cms/s/0/be03d45c-a666-11e0-ae9c-00144feabdc0.html). At issue here is the propensity of governments to tactically understate the inflationary consequences of unrestrained public spending.

We have understated inflation in the US for more than a decade by promoting misleading statistics such as the Consumer Price Index (CPI). Today we are taking this a step further. As part of recent debt ceiling negotiations in Washington, one proposal emerged that would index Social Security payments to the Chained Consumer Price Index (C-CPI), an index that understates inflation even more than the CPI. This is a gimmick designed to reduce payments to seniors by pretending that inflation is lower than it is. Are Americans really that gullible?

While we can be creative with inflation accounting, it is challenging to look at the following chart without acknowledging that we face a daunting inflation problem that is global in nature:

In the BRIC nations where money supply growth exceeds 20%, inflation is already in the danger zone, even as measured by the understated "official" indexes:

The correlation here between BRIC country money supply growth and inflation is unmistakable. While the rest of us (the non-BRICs) appear to have a modest amount of breathing room, real monetary reform is required to reverse our ascent into the circle on the above chart. For the US, our proximity to that circle is closer than it appears as the recent trippling of the monetary base has not yet found its way into the broader money supply.

Our current effort to restrian spending by means of a so-called debt ceiling is futile. The availability of unlimited central bank credit makes it possible to lift the debt ceiling, as congress has done 11 times since 2001, whenever a spending “crisis” emerges. A modernized gold standard, on the other hand, would limit the ability of the central bank to provide such financing and it would compel the treasury to live within its means. Tough talk? Perhaps, but why not move forward to a more sustainable monetary regime now while we still have some flexibility? If we wait, we will be forced to react within the confines of an inflation problem in which cost of living expenses are rising much more rapidly than wages. By that time our choices will be limited and less attractive.

In 2009 I wrote an article (http://www.kitco.com/ind/Potter/nov042009.html) about the significance of the Bank of India's purchase of 200 tons of gold from the IMF. After decades of being net sellers, it seemed that collectively, central banks were on the verge of becoming net buyers of gold. Despite long dated conventional wisdom to the contrary, central banks did indeed buy more gold than they sold the following year (2010).

According to the World Gold Council's 2011 First Quarter report, "The latest data reported by the IMF suggests that central banks remained net buyers of gold through February of 2011 as a major shift in behavior among central banks continues to unfold." The report goes on to state that European central banks have simply lost their "appetite" for exchanging valuable gold reserves for paper money and emerging market central banks are buying gold to diversify their growing US dollar reserves (the result of excess, newly created dollars flowing abroad). The most striking example of this is the recently reported purchase by the Central Bank of Mexico (http://www.ft.com/cms/s/0/cbc02e10-7637-11e0-b4f7-00144feabdc0.html#axzz1LanAPUvl). Mexico just bought 100 tons of gold, increasing their reported gold reserves by over 1300%.

There are several implications of this shift in behavior. First, the sheer size of excess foreign reserves (newly created paper money) is literally scaring central bankers into an informal gold standard – they are not implementing gold convertibility but they are certainly choosing gold, rather than paper to back their liabilities. Second, the manufacturers of our money, our Central bankers, are questioning the value of their product. While we are unlikely to hear a central banker argue for a modern day gold standard anytime soon, it sure seems that they understand the need for one.

Recently a New York Times article screamed “Prices Surge as Investors Rush to Safety of Gold.” In reality there was no rush and the gold price did not surge. Gold was up less than 0.5% on the day in question and is up only 6% in 2011, less than the increase in the S&P 500. For 10 years, the gold price has edged quietly higher, rarely moving more than 1% up or down on any given day. Along the way, the media argued that each new high was driven by panicked investors who were fleeing from equities. I would argue just the opposite. Individuals and institutions, reacting rationally to expansionary monetary policy, are merely exchanging cash balances for gold. This has little to do with geopolitical turmoil or perceived troubles in the economy and stock market. It is a currency trade, pure and simple.

The basic mechanics of monetary policy and money creation remain a mystery to most people. Few are aware that most new treasury debt is purchased by the Federal Reserve with brand new dollars; that China buys large quantities of dollars every day with newly minted Yuan or that Japan created 39 trillion ($481 billion) new Yen in the two weeks following the earthquake. As James Grant points out in his March 25th Interest Rate Observer, “when the materialization of nearly a half-trillion dollars in a fortnight’s time stops astounding reporters, it’s past time for a monetary reappraisal.” Perhaps reporters are more unaware than unimpressed. With everyone printing at once, the value of one currency relative to another (the exchange rate) never reflects the magnitude of the new supply of money. All currencies decline together while appearing to not decline at all. While this provides ample cover for our central bankers to perpetuate the print-off, it results in inflation, progressively severe boom and bust cycles, perpetual deficits and an increasing inequality of wealth.

Under a gold standard, in which paper money is convertible into a fixed weight of gold, the threat of dollar to gold conversion compels monetary restraint on all central banks. In our present unreserved monetary system, that threat has become reality and the qualities that define our money as sound have been transferred, at the margin, from paper to gold. We have seen the creation of gold denominated shares by hedge fund manager John Paulson and others; the passage of a bill in the Utah legislature allowing gold and silver coins to be used as legal tender; and the conversion of cash balances into gold bullion by major investment and endowment funds. Even the manufacturers of our money have been exchanging paper for gold - witness the buying of bullion by the central banks of India, Bangladesh, Sri Lanka, China and Thailand over the last year.

Economic stimulation through currency depreciation is the unwritten, unspoken policy of today’s monetary leaders. While our Federal Reserve receives a disproportionate amount of the blame for this dangerous game, all central banks are active participants. In response, gold is predictably performing its role as the only supply constrained currency – its price is adjusting upward. Despite the headlines, it has done so in an orderly, methodical way for over a decade. Other commodity prices have risen as well, but only the gold price has risen with a consistently tight correlation to the growth in world money. This has won converts to the idea that gold must be the centerpiece of monetary reform. It has also shortened the road forward to a modernized gold standard.